Commentary: Deflation appears vanquished, but where are we headed?

For the moment, it’s all good. After veering dangerously close to deflation, the rate of inflation has picked up and has now reached 2% — the fastest pace in 20 months. As recently as eight months ago, the 12-month change in consumer prices was only 1%.

At that time, the money mavens over at the Federal Reserve were biting their nails. Statistically, 1% inflation is little different from deflation. As a matter of fact, since the price indexes are averages of a multitude of prices, when the overall index goes up by only 1%, you can be sure that many prices are already falling.

Like any central bank, the Fed worries more about deflation than about inflation — especially these days, when the Fed’s No. 1 concern seems to be unemployment. Joblessness aside, deflation is tougher for monetary policy to deal with than inflation.

To arrest inflation, all the Fed has to do is reduce the money supply. As the late, great economist Milton Friedman once said: “Inflation is always and everywhere a monetary phenomenon.” Translated, this means you can’t have inflation without a corresponding jump in the money supply.

Deflation is a horse of another color. When prices fall, people usually wait for them to go lower before buying. For its part, business waits for demand to stop falling before hiring. You can see where this can become a vicious cycle, one that is not amenable to correcting by extra money alone.

Does 2% inflation mean that those money mavens can breathe easier? Not yet, for two reasons: First, the change in the index that the Fed prefers is only 1.6%. Second, officials have suggested that they would like to see inflation rise above 2% to ensure that the fledgling recovery doesn’t succumb prematurely.

Naturally, the Fed will have to remain vigilant as it allows inflation to rise, since price changes can and usually do fluctuate. And with all the liquidity that the central bank has pumped into the economy, it is not a stretch to worry that inflation will go higher before it goes lower.

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Meanwhile, let us not overlook what higher inflation has already done to workers, savers and seniors.

After taking inflation into account, workers’ real wages fell 0.2% in May and are down 0.1% over the past 12 months. Seniors and others on fixed incomes have found that the buying power of the funds they already have is down as well.

This limits how much people can spend. It also limits how high inflation will go.

That said, you may expect the Fed to keep monetary policy easy, its tapering of long-term bond purchases notwithstanding. Unless and until economic growth increases enough to sop up more of the unemployed, the Fed will find a way to keep interest rates low and money flowing into the financial system.

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